Virtus Foreign Opportunities Fund
4Q 2016 COMMENTARY
International equities withstood a multitude of shocks in 2016. Despite economic and political uncertainty weighing on markets at times, equities performed reasonably well, helped by the outperformance of emerging market stocks for the majority of the year, which was driven by the Federal Reserve’s deceleration of monetary policy normalization, strengthening commodity prices, and improving fundamentals.
Risk aversion dominated markets early in 2016 as investors contemplated falling oil prices, slower growth in China, and changing Fed monetary policy. By the second quarter, encouraging economic data and supportive central bank policies strengthened European equities, although the United Kingdom’s vote to exit the European Union eclipsed other developments. The Brexit vote was followed by a sell-off in global risk assets and a sharp decline in the British pound against its major trading currencies.
International equities recovered rapidly from the Brexit sell-off, and high quality stocks participated in the rally. Equity markets responded positively to continued loose monetary policy in developed markets, as well as OPEC’s tentative agreement to cut oil production, and equity performance of key emerging markets, such as China, Brazil, Korea, and Taiwan, strengthened. Shortly thereafter, however, sentiment changed and began to reflect a belief that the benefits of expansionary monetary policies had been exhausted. This change in views spurred a rotation into cyclicals and financials and out of consumer staples, telecommunications services, and utilities, a rotation which continued through the end of 2016. In the fourth quarter, Donald Trump’s surprise victory in the U.S. presidential election sparked a reflation rally in the U.S. and most developed markets, driven by his promises to implement pro-business polices and fiscal stimulus.
In general, the pro-business aspects of Trump’s platform—lowering taxes, reducing regulation, and boosting infrastructure spending—are aimed at stimulating economic growth. If successful, they could result in higher inflation, as well as higher interest rates. The prospect of higher growth also sent bond yields higher, reinforcing the rotation out of equities that are perceived as “bond proxies.”
Equities in Europe and the United Kingdom gained during the fourth quarter’s rally with rising interest rates supporting improvements in financials, although U.S. dollar returns were affected by declines in local currencies. European equities were supported by positive economic news during the quarter, including falling unemployment, rising inflation, and gains in consumer sentiment. A weaker euro may prove to be a boon for exporters in some European countries. In emerging markets, equities came under pressure over the quarter. Investor concerns about rising interest rates, a strong U.S. dollar, and potential changes to U.S. policy resulted in significant capital outflows, and renewed concern about dollar-denominated debt.
Most major international developed countries continued to benefit from accommodative monetary policy. The European Central Bank (ECB) announced its intention to continue quantitative easing through 2017, although it will begin to taper in April. The Bank of England embraced looser monetary policy following the U.K. Brexit vote, and the Bank of Japan implemented a new monetary policy approach that gives policymakers the option to increase or decrease bond purchases, as long as 10-year government bonds remain near the target yield of zero percent.
A confluence of events in the fourth quarter created headwinds for our high quality style, leading to the Fund's negative performance. The difficult environment led us to give back returns that the strategy had generated in the first half of 2016, ending the year in negative territory and underperforming the benchmark MSCI EAFE® Index.
In the second half of the year, market sentiment bolstered risk assets. The Fund’s performance was driven by this strong momentum away from quality names, rather than a deterioration in the fundamentals of our portfolio holdings. In fact, this year many of our companies continued to deliver earnings growth in line with our expectations and consistent with that of previous years. Where there were issues with either growth or valuations, we adjusted holdings accordingly.
Consumer staples was the largest detractor from fourth quarter performance, resulting from the market rotation out of quality. Our consumer staples holdings slightly underperformed the staples sector of the MSCI EAFE Index; however, our large overweight to staples was the main contributor to the negative performance. British American Tobacco, Anheuser-Busch InBev, and Reckitt Benckiser were three of our larger portfolio holdings that underperformed. We have long held a significant overweight to consumer staples companies due to our bottom-up focus on high quality growth franchises with deep moats. While investors who view staples as defensive or a dividend play rotated out of the sector, as a buy-and-hold asset manager, we continue to view staples as an attractive sector. Demand for products that staples companies sell is not economically sensitive. We are able to find staples companies with earnings derived from a broad set of geographies and products, which helps reduce risk to the underlying earnings stream within our portfolios. And, we believe many staples companies have strong brands which results in superior profitability.
In the financials sector, our holdings UBS and Lloyd’s Banking Group performed well, but our lack of exposure to other European banks (BNP Paribas, Banco Santander, Societe Generale) and Japanese banks (Mitsubishi UFJ Financial Group) hurt relative performance as these firms rallied over the quarter. We have taken a cautious approach to European and Japanese banks based on their low ROEs. In Europe, there is also uncertainty because of potential political risks. Our long-held Indian financials — HDFC Bank, a leading retail bank, and Housing Development Finance Corporation a leading mortgage lender — both pulled back over the quarter. Their share prices came under pressure from both the reversed fund flows from emerging markets back to developed markets in the quarter. In addition, the impact from India’s currency reform led to market uncertainty about broad economic activity. However, we believe these specific reforms in India will be a benefit to these holdings over the medium and long term as the formal economy grows and some of the traditional cash savings are encouraged into the banking system as deposits.
Our lack of exposure to the energy sector also detracted from relative performance as OPEC’s agreement to its first oil production cuts in eight years led to a rally in energy producers.
Our overweight to the health care sector also weighed on returns, with pharmaceuticals continuing its broad-based sell-off. Ramsay Health Care and Roche Holdings underperformed. Novo Nordisk, a Danish pharmaceuticals company, corrected sharply in late October when the company lowered its mid-term target for operating profit growth to 5%. The main culprit is price erosion in the long-acting insulin segment because of a new competitor entering the space. Thus, although our position in Novo is smaller than it used to be (due to its lower growth profile), we believe it is still a far better-than-average company.
From a country perspective, our Japanese holdings Unicharm and Japan Tobacco detracted from returns as did our Mexican holding, Fomento Economico Mexicano (FEMSA). While there may be short-term volatility in its share price and a weakened peso stemming from Trump’s immigration and anti-trade rhetoric, we are comfortable holding companies like FEMSA. The company operates OXXO, Mexico's largest and fastest growing convenience store chain, is a 48% owner of Coke FEMSA, one of the largest Coca-Cola bottlers in the world, and has 20% ownership of the global brewer Heineken. We believe FEMSA is a powerful franchise and an enduring growth business that is consistent with our longer-term investing view.
Although the sharp rotation out of sectors perceived as “bond proxies” hurt the Fund due to our positions in consumer staples, it slightly aided the strategy due to our lack of exposure to telecommunication services and utilities.
A new addition to the portfolio, France’s LVMH Moet Hennessy Louis Vuitton added to returns. The company continues to perform well strengthened by the core LV brands, with launches in the mid-price range, and Fendi’s strong results. Canadian National Railway also helped performance. Similar to other stocks linked to growth of the U.S. economy, its share price rose on the back of the U.S. election.
Throughout 2016, we notably increased the Fund’s weight to industrials stocks. At the same time, we reduced exposure to health care given market concerns about limits on drug prices in the U.S.
Over the fourth quarter, we purchased consumer discretionary stock LVMH Moet Hennessy Louis Vuitton SE (“LV”), a group of brands that engages in the manufacture of luxury goods. We believe the LV brand, which represents nearly 50% of the company’s EBIT, has good pricing power, as evidenced by its operating margins which have remained at approximately 42%. LV’s stable growth is supplemented by faster growing brands within the portfolio, including Fendi in fashion and leather, Sephora in selective retail, and Bvlgari in jewelry. We expect margins to improve, driven by the sale of DKNY, which generated losses, and the exit from the unprofitable Hong Kong airport DFS (Duty Free Shop) contract.
In the consumer staples sector, we purchased Ambev SA and Fomento Economico Mexicano (“FEMSA”), two long-term positions in our Emerging Market Equity Strategy. Ambev is the dominant Brazilian brewer and also has a strong presence in non-alcoholic beverages. The stock has been weak due to the political and economic issues in Brazil. Over the long term, we think it is a solid company that dominates the beer market in Brazil and in other Latin American countries. Buying a great business that is currently experiencing a difficult time because of the surrounding macro environment should yield great returns in the long run. During this weak environment, the company is continuing to invest in its brands and distribution and we believe should emerge even stronger when the macro environment improves.
FEMSA is the leading beverage company in Latin America. FEMSA has long-term growth opportunities based on stable consumption trends, market share gains, pricing power and scale. The company has a deep history managing through currency and debt crises, a strong balance sheet, and the ability to finance itself with local as well as foreign denominated debt. These are characteristics that we feel embody a quality investment and a resilient franchise.
We added to our existing positions in Canadian National Railway (“CN”) and Anheuser Busch Inbev (“ABI”). We believe CN will return to positive volume growth in 2017. With stronger demand, there may be room for CN to raise prices above consensus. ABI dominates the beer market, with roughly one-fourth of beer volumes and close to one-half of beer profits globally. With the combined ABI/SABMiller (“SAB”) business, it is now more exposed to faster growing markets. This should lead to both fast top- and bottom-line growth and a sales increase from using the legacy SAB distribution in its emerging markets to sell ABI’s global beer brands. Once SAB is digested and the debt reduced, ABI is likely to generate high levels of free cash and will either do another accretive acquisition or return large amounts of cash to shareholders, either of which would be beneficial to shareholders. Although currently several of its markets, such as Brazil and Mexico, are going through rough patches, but longer-term, this dominant franchise should remain strong.
Over the quarter, we sold SABMiller Limited as it was purchased by ABI. We also sold ITC Limited and Alphabet and reduced our position in Imperial Brands as we reallocated capital to better opportunities.
THE IMPORTANCE OF PERSPECTIVE
We believe it is helpful to look at the Fund's performance from a broader perspective, and compare short-term returns with longer-term excess returns. Short-term performance is heavily influenced by valuation, one of the three main drivers of returns, while earnings growth and dividends have less effect. Over longer observation periods, earnings growth and dividends have a greater influence on total shareholder return. The chart below compares excess returns of the Fund against the MSCI EAFE Index for both 3-and 36-month rolling periods. Looking at the Fund's track record of excess returns, it is apparent that we have gone through a number of periods of underperformance, but over 3-year rolling periods, the Fund's excess returns have been considerably more consistent than during the shorter periods, resulting from solid performance from the underlying holdings. This distinction we feel is key. We look to outperform the market with less volatility over a full market cycle, and short-term underperformance during times of market optimism are part of our investment profile, albeit at times painful. We maintain conviction in our quality style of generating alpha by investing in steadily growing companies that compound earnings over long time periods.
ADDRESSING PERIODS OF UNDERPERFORMANCE: 2009, 2013, AND TODAY
Late in the first quarter of 2009, fears of economic depression dissipated after the global financial crisis, equity markets rallied, and investors preferred the shares of more highly leveraged and cyclical companies throughout much of the year. Even when there was a significant disparity between the anticipated operating performance of these companies and their relative share performance, investors remained optimistic. Meanwhile, shares of higher quality, more stable companies, which had lost less ground when investors’ fears were peaking, appreciated but underperformed on a relative basis.
In 2009, U.S. Fed Chairman Ben Bernanke signalled that the Fed would “taper” quantitative easing, which while initially seen as a negative in terms of withdrawing support for providing ultra-loose monetary policy to support growth, came to be seen as a positive throughout the year because the economy showed signs of improvement. From the announcement in May 2013, the U.S. market was up 13% through year-end 2013. Financials, on the perception of future rate/yield rises, outperformed the S&P 500® while consumer staples lagged. Europe, on the back of ECB President Mario Draghi’s support, saw similar types of performance during this time period as well, with consumer staples underperforming and financials outperforming. Lastly, there was a rotation out of emerging markets, especially those countries with U.S. dollar-denominated debt exposure and high current account deficits, into developed markets.
Fast forward to 2016 and an environment that is similar to that of 2009 and 2013, where lower quality stocks outperformed. Trump's election, the impending impact of Brexit, and potential inflationary policies have driven long-dated Treasury yields higher. Also, commodity prices have risen on OPEC cuts and infrastructure growth speculation. The result has been a rotation from sectors perceived as bond proxies (consumer staples, telecommunication services, and utilities) into cyclicals and financials.
2017 OUTLOOK: FOCUS ON EARNINGS AMID UNCERTAINTY
We believe the global economic recovery will continue in 2017. Developed economies are likely to continue strengthening, albeit slowly. Since the 2008 financial crisis, developed economies have benefited from the extraordinary measures undertaken by major central banks and the healing that comes from the passage of time. The U.S. economy remains on especially solid footing. Real GDP is expected to rise from around 1.6% in 2016 to more than 2.0% this year. Importantly, labor conditions have noticeably improved—the unemployment rate has declined to a nine-year low—and inflation is now moving towards the Fed’s 2.0% target (Source: Bloomberg). Prospects for the eurozone, however, are less robust, where a number of banks continue to restructure, and it is difficult to isolate how much of the current recovery across the periphery nations is underwritten by the ongoing quantitative easing from the ECB. Thus, even if the Federal Reserve tightens policy further this year, as expected, the ECB and Bank of England are unlikely to withdraw monetary accommodation anytime soon with the looming confidence risks of the Brexit negotiations kicking into gear and upcoming elections in France (April 2017) and Germany (second half of 2017).
Equity markets have rallied since the U.S. election and are looking for Trump’s administration to launch a number of initiatives designed to accelerate growth of the U.S. economy and bring income growth back to the middle classes. While this optimism may be warranted, we are cautious about the U.S. equity market getting too far ahead of itself and underappreciating potential risks, particularly in regards to timing.
This paradigm shift presents new challenges for global investors. For several decades, investors have become accustomed to a constant direction in the world economy, led by the U.S. and other developed markets outsourcing production to lower cost emerging market-based companies. Any shift in the U.S. position on trade direction is likely to have a magnified impact on global supply chains and, if so, could result in a number of secondary impacts. This naturally would have a bottom-up impact for many companies, particularly those that export to the U.S. as an important part of their business.
Given this uncertain backdrop, we are constantly evaluating and re-evaluating opportunities for sustainable earnings growth driven by what we believe are solid structural drivers. We have rarely found the labor or regulatory arbitrage of emerging market to developed market exporters of lower value-added products attractive and do not hold any companies where this is the primary driver of their earnings. If a company is to export, then we feel a barrier greater than a cheap currency or low wages is vital and look for companies that could stand on their own two feet even if they were located in developed markets, e.g., certain Indian generic pharmaceutical companies that develop and own proprietary intellectual property.
We continue to carry out our rigorous analysis to ensure our existing holdings remain in a position to deliver the long-term growth we seek. We have learned over a number of market cycles that, when the markets are on a cyclical rally, it is important to maintain the discipline of our style and keep focused on long-term earnings, as this is what we believe is the key driver to long-term returns. In the near term, this can lead to market underperformance while valuations fluctuate, but over the long term, we strongly believe earnings growth and dividends are far greater contributors to returns than swings in valuation multiples.
INVESTMENT CASE STUDY: European Financials
In Europe, many financials have done well in the latter part of 2016. One reason for this is slightly higher long-term interest rates (based on marginally stronger economic news and expectations for a less aggressive quantitative easing). This is positive for banks’ net interest margins. In addition, some European investment banks (e.g., Deutsche Bank, Barclays) have substantial U.S. subsidiaries which are presumed to benefit from the expected regulatory relief in the U.S. The smaller-than-feared fine imposed by the Department of Justice on Deutsche Bank (for misselling mortgage-backed securities prior to the 2008 financial crisis) has also helped to assuage investors that the worst is probably over in terms of severe penalties for misdeeds that occurred in the years leading up to the crisis.
While the developments described above are helpful to a number of European banks, it is important to keep in mind that, as a group, they are still not earning their cost of equity. Most European banks will not be able to earn a double-digit ROE this year or next year. Furthermore, there are substantial political risks in the coming months (e.g., the French election) to which banks are particularly vulnerable. Finally, loan growth is de minimis in most European countries. Thus, while it would be positive for banks if interest rates have indeed bottomed out, there are many other reasons for quality managers to avoid broad exposure to European financials. We are comfortable with our select investments in better quality financials that generate high ROEs and have strong capital positions. In addition, they are based in countries that are less likely to see substantial economic dislocations. Despite the recent rally, however, we will continue to adhere to our investment discipline and remain very selective, as most European Financials do not meet our quality standards.